Squaring Off Over R&D Spending

12/18/2003 --

ANN ARBOR, Mich.---Deciding how much a company should spend on research and development in a given year can become a bone of contention, especially in R&D-intensive firms.

Increased R&D spending benefits shareholders by helping to stimulate firm growth and providing a competitive advantage, but it negatively impacts short-term accounting and stock performance, which in turn, can affect CEO compensation and job security.

CEOs typically weigh the benefits and costs of R&D spending and invest only when the expected personal benefits dominate the expected personal costs, says Shijun Cheng, assistant professor of accounting at the University of Michigan Business School. A CEO has a greater incentive to cut R&D investment when he or she approaches retirement (a horizon problem) or when a firm faces a small earnings decline or loss and could reverse a poor performance by inflating current earnings (a myopia problem).

In a study forthcoming in the Accounting Review, Cheng investigates whether the compensation committees of boards of directors seek to deter opportunistic reductions in R&D expenditures when the horizon and myopia problems are present by adjusting CEO incentive arrangements. He studied 160 Forbes 500 firms in R&D-intensive industries over the period 1984 to 1997 and examined the association between changes in R&D spending and changes in the value of CEO compensation.

Cheng found that for an average firm, a $1,000 increase in R&D expenditure is associated with a $2.84 increase in the value of CEO annual option grants in the presence of the horizon problem, and a $4.32 increase if the myopia problem is evident. When both problems are present, CEO option compensation increases by $7.08 and total compensation by $7.12.

His findings suggest that compensation committees can adjust CEO annual option compensation to mitigate opportunistic reductions in R&D spending. This effect is strong only when the horizon and myopia problems are present. Similar results also hold for changes in CEO total annual compensation (i.e., the sum of salary, annual bonus, stock options and other long-term incentives), but not for changes in CEO cash compensation (i.e., the sum of salary and annual bonus).

"This study shows how firms, acting through compensation committees, address situations where opportunistic reductions in R&D spending are more likely," Cheng said. "By establishing a greater positive association between changes in R& D spending and changes in CEO stock options---which are linked to long-term performance and motivate long-term investments such as R&D spending---a committee can make increasing R&D spending more beneficial and reducing it more costly to the CEO."

For more information, contact:
Bernie DeGroat
Phone: 734.936.1015 or 734.647.1847
E-mail: bernied@umich.edu